Friday, October 07, 2011

Notes on a Worldly Philosopher

The very first book on economics that I remember reading was Robert Heilbroner's majesterial history of thought The Worldly Philosophers. I'm sure that I'm not the only person who was drawn to the study of economics by that wonderfully lucid work. Heilbroner managed to convey the complexity of the subject matter, the depth of the great ideas, and the enormous social value that the discipline at its best is capable of generating.

I was reminded of Heilbroner's book by Robert Solow's review of Sylvia Nasar's Grand Pursuit: The Story of Economic Genius. Solow begins by arguing that the book does not quite deliver on the promise of its subtitle, and then goes on to fill the gap by providing his own encapsulated history of ideas. Like Heilbroner before him, he manages to convey with great lucidity the essence of some pathbreaking contributions. I was especially struck by the following passages on Keynes:

He was not without antecedents, of course, but he provided the first workable intellectual apparatus for thinking about what determines the level of “output as a whole.” A generation of economists found his ideas the only available handle with which to grasp the events of the Great Depression of the time... Back then, serious thinking about the general state of the economy was dominated by the notion that prices moved, market by market, to make supply equal to demand. Every act of production, anywhere, generates income and potential demand somewhere, and the price system would sort it all out so that supply and demand for every good would balance. Make no mistake: this is a very deep and valuable idea. Many excellent minds have worked to refine it. Much of the time it gives a good account of economic life. But Keynes saw that there would be occasions, in a complicated industrial capitalist economy, when this account of how things work would break down.

The breakdown might come merely because prices in some important markets are too inflexible to do their job adequately; that thought had already occurred to others. It seemed a little implausible that the Great Depression of the 1930s should be explicable along those lines. Or the reason might be more fundamental, and apparently less fixable. To take the most important example: we all know that families (and other institutions) set aside part of their incomes as saving. They do not buy any currently produced goods or services with that part. Something, then, has to replace that missing demand. There is in fact a natural counterpart: saving today presumably implies some intention to spend in the future, so the “missing” demand should come from real capital investment, the building of new productive capacity to satisfy that future spending. But Keynes pointed out that there is no market or other mechanism to express when that future spending will come or what form it will take... The prospect of uncertain demand at some unknown time may not be an adequately powerful incentive for businesses to make risky investments today. It is asking too much of the skittery capital market. Keynes was quite aware that occasionally a wave of unbridled optimism might actually be too powerful an incentive, but anyone in 1936 would take the opposite case to be more likely.

So a modern economy can find itself in a situation in which it is held back from full employment and prosperity not by its limited capacity to produce, but by a lack of willing buyers for what it could in fact produce. The result is unemployment and idle factories. Falling prices may not help, because falling prices mean falling incomes and still weaker demand, which is not an atmosphere likely to revive private investment. There are some forces tending to push the economy back to full utilization, but they may sometimes be too weak to do the job in a tolerable interval of time. But if the shortfall of aggregate private demand persists, the government can replace it through direct public spending, or can try to stimulate additional private spending through tax reduction or lower interest rates. (The recipe can be reversed if private demand is excessive, as in wartime.) This was Keynes’s case for conscious corrective fiscal and monetary policy. Its relevance for today should be obvious. It is a vulgar error to characterize Keynes as an advocate of “big government” and a chronic budget deficit. His goal was to stabilize the private economy at a generally prosperous level of activity.

This is as clear and concise a description of the fundamental contribution of the General Theory that I have ever read. And it reveals just how far from the original vision of Keynes the so-called Keynesian economics of our textbooks has come. The downward inflexibility of wages and prices is viewed in many quarters today to be the hallmark of the Keynesian theory, and yet the opposite is closer to the truth. The key problem for Keynes is the mutual inconsistency of individual plans: the inability of those who defer consumption to communicate their demand for future goods and services to those who would invest in the means to produce them.

The place where this idea gets buried in modern models is in the hypothesis of "rational expectations." A generation of graduate students has come to equate this hypothesis with the much more innocent claim that individual behavior is "forward looking." But the rational expectations hypothesis is considerably more stringent than that: it requires that the subjective probability distributions on the basis of which individual decisions are made correspond to the objective distributions that these decisions then give rise to. It is an equilibrium hypothesis, and not a behavioral one. And it amounts to assuming that the plans made by millions of individuals in a decentralized economy are mutually consistent. As Duncan Foley recognized a long time ago, this is nothing more than "a disguised form of the assumption of the existence of complete futures and contingencies markets."

It is gratifying, therefore, to see increasing attention being focused on developing models that take expectation revision and calculation seriously. A conference at Columbia earlier this year was devoted entirely to such lines of work. And here is Mike Woodford on the INET blog, making a case for this research agenda:

This postulate of “rational expectations,” as it is commonly though rather misleadingly known... is often presented as if it were a simple consequence of an aspiration to internal consistency in one’s model and/or explanation of people’s choices in terms of individual rationality, but in fact it is not a necessary implication of these methodological commitments. It does not follow from the fact that one believes in the validity of one’s own model and that one believes that people can be assumed to make rational choices that they must be assumed to make the choices that would be seen to be correct by someone who (like the economist) believes in the validity of the predictions of that model. Still less would it follow, if the economist herself accepts the necessity of entertaining the possibility of a variety of possible models, that the only models that she should consider are ones in each of which everyone in the economy is assumed to understand the correctness of that particular model, rather than entertaining beliefs that might (for example) be consistent with one of the other models in the set that she herself regards as possibly correct...

The macroeconomics of the future, I believe, will still make use of general-equilibrium models in which the behavior of households and firms is derived from considerations of intertemporal optimality, but in which the optimization is relative to the evolving beliefs of those actors about the future, which need not perfectly coincide with the predictions of the economist’s model. It will therefore build upon the modeling advances of the past several decades, rather than declaring them to have been a mistaken detour. But it will have to go beyond conventional late-twentieth-century methodology as well, by making the formation and revision of expectations an object of analysis in its own right, rather than treating this as something that should already be uniquely determined once the other elements of an economic model (specifications of preferences, technology, market structure, and government policies) have been settled.

I think that the vigorous pursuit of this research agenda could lead to a revival of interest in theories of economic fluctuations that have long been neglected because they could not be reformulated in ways that were methodologically acceptable to the professional mainstream. I am thinking, in particular, of nonlinear models of business cycles such as those of Kaldor, Goodwin, Tobin and Foley, which do not depend on exogenous shocks to account for departures from steady growth. This would be an interesting, ironic, and welcome twist in the tangled history of the worldly philosophy.

Laibson presented a paper on natural expectations (applied to finance) at the Columbia conference mentioned in the post. In general I'm skeptical of the behavioral approach, especially in the context of finance because strong selection pressures make financial market behavior both psychologically atypical and very history dependent. The behavioral economists are more inclined to work with psychologically typical behavior identified in laboratory environments.

Yes a nice set of diff equations can mimic the motions of a market system but ...it's a parrot in the end no matter how clever Agents cam make choices even if the choices are themselves historically determined in some hidden fine structure of the agent. A fine structure I suspect sufficiently simulated by A few well designed heterogeneous" agent types"

I suspect that the term "expectations" is muddying the waters. I believe Keynes was quite aware of what we now call "coordination" problems, and had a pretty clear idea of the resulting multiplicity of equilibria. (The famous "beauty contest" passage is parable about this problem in financial asset pricing.) The low-level equilibria are not, from this point of view, just the result of depressed "expectations" of what will actually happen, but of self-fulfilling "expectations" about how other agents will react. I discussed the general form of this type of model in my Gildersleeve Lecture. This line of thinking leads back to Cooper-John and to Diamond's unemployment model as bases for reconstructing the "microeconomic foundations" of macro.

Prof. Sethi writes: 'But the rational expectations ... requires that the subjective probability distributions on the basis of which individual decisions are made correspond to the objective distributions that these decisions then give rise to. It is an equilibrium hypothesis, and not a behavioral one. ... . As Duncan Foley recognized a long time ago, this is nothing more than "a disguised form of the assumption of the existence of complete futures and contingencies markets." '

The latter assertion, quoting Foley, is a fallacious claim. We all know that we can still have models with incomplete markets and still have consistently defined rational expectations equilibrium concepts.

Morth3, I suggest you read the Foley article. He does not claim that you can only have RE in complete market models, just the opposite in fact. He is saying that the coordination of individual plans that RE assumes only makes sense in a complete market setting because without it, there is no mechanism for coordination of future plans.